Econ 110 Midterm 2 Review

Italics designate a graph that should be known

Some notes:
1. Firms always produce at Q where MC=MR. This is where they are maximizing profit, so
we assume this is how they choose the quantity to produce at. But this has nothing to do
with efficiency.
2. Profit = TR-TC = Q(P-ATC). This second equation (profit per unit x Q) is important. This
is how you see profits on our graphs.
3. Thus, with 1 & 2, we have a sequence for what firms do when left to their own devices:
1. First, find Q being produced. This is where MC = MR.
2. Then, find price that is being charged.
b. Efficiency has several definitions. They all mean the same thing
1. Maximize CS+PS (which equals net social welfare or total surplus)
2. MWTP = MC (aka D=S. Also, D=P=AR=MB) (so, as you can see, there are
several ways to tease this out. On a monopoly graph, it will be where MC = D.
With externalities, it will be where social MB = social MC. But this all means the
same thing)
b. Deadweight loss is a result of inefficiency. It measures where our inefficiency is coming
from. Thus, it is the consumer or producer surplus we are missing out on because we are
not at a point where MC=MWTP. So, all you need to do is draw a graph. Look at where
our CS and PS would be if MC=MWTP, then look at where CS and PS is with the
problem. This problem I am referring to could be anything: monopoly, tax, price ceilings,
externalities, etc. DWL is the same in every case. Its the loss of total surplus because we
are not at an efficient point.
HW 5 through HW 8
HW 5
o 5 PC (chicken market)
Plot over t
6 shut down rule (skateboard shop)
HW 6
2 how could a country import but not export
5 forex market
11 minimum wage and union
12-14 trade, tariff, quota
17 taxes with equations
HW 7
11 monopoly and efficiency
12 price ceiling on nat monopoly and PC
13 3 partners
HW 8

Ch. 10 Competitive Markets and Efficiency

Positive vs. normative analysis
Prices and profits
o Incentives: Prices (to ration among demanders and incentivize firms production)
and profits (incentive to enter or exit)
o EX: Increase in demand
SR: DP, Q
Price: available output is rationed by willingness to pay market
price will increase until those willing to pay at least the current
market price are able to purchase available outout
Price: price stimulates production, use inputs more intensively
Profits: Entry
LR: S, further Q, P returns to original
EX: Decrease in demand
EX: Increase in production costs
SR: Decrease SInc P, Dec Q
LR: Increase in elasticity of demandsmall dec of P, Q falls
further
Price, quantity, and profits plotted over time for prev 3 examples
Information
Role of prices
Role of profits
Linkages
Arbitrage
Allocative efficiency (both explanations, MWTP = MC and max NSW, can be seen
on a graph)
Def 1: MWTP=MC
MWTP=D=AR=P=MB(for consumer)
MC=S
Both S and D are social S and D (as opposed to private)
Def 2: Maximizes net social welfare = CS + PS
Consumer surplus
Producer surplus
Why competitive markets are efficient
Another look:
MS /MS =p /p
Derivation:
Equi-marginal rule: MS/p is = for all goods
Rearrange equation
MS /MS marginal rate of substitution in consumption
And all consumers pay the same prices, so MS /MS must hold for
all consumers
MC /MC =p /p
Producer side, same derivation
A

MC /MC marginal rate of transformation in production

Other efficiencies:
Adjustment efficiency: do markets adjust to changes and shocks more
quickly than can alternatives
Informational efficiency: do markets gather and transmit information
about demand and supply more quickly than alternatives
Dynamic efficiency: do markets stimulate and reward individual initiative
to change and innovate

Ch. 11 International Trade

Why trade? Comparative advantage (PPFs, opportunity costs, absolute advantage, etc.)
Trade markets. Know these on a graph:
o Exporting and importing countries
o Shifts in world price for exporting or importing countries (inc. tariffs)
o Gains from trade in CS and PS
Money in international trade
o Foreign exchange markets
Exchange rates
Appreciation/depreciation
Supply and demand of foreign exchange. Market for forex and how it
deals with shocks
Trade imbalances
Net exports = EX IM
Trade deficit/surplus
How trade imbalances disappear naturally
Exception^: if foreigners want to hold domestic assets
Ch. 12 Market Distortions
Commodity taxes
o Av valorem (%) vs. specific commodity taxes ($s)
o Market effects = graph. Be able to see:
Tax revenue
Deadweight loss
Tax incidence/buren
Market subsidies
Price ceilings - shortage
Rationing solutions:
Waiting/time/first come first serve
Lottery
Coupon
Bureaucratic/fiat
Historical use
Reallocation & black markets
Innovations
Tied sales

Producing close substitutes

Lowering quality
In-kind payments
LR effects dec supply
Price floors surplus
Disposal solutions
Let it go to waste
Government purchase (inc D)
Government subsidy (inc D)
Limit production (dec S)
Innovations
Purchasing substitutes
Using input more intensively
Tied sales
Changing quality (nonprice competition)
LR: inc S, requires more govt to prop up price floor
Restrictions on entry
Licensing
Limited training
Limiting substitutions
Graph: DWL b/c S is too far back
Prohibited markets
Penalizing suppliers
Penalizing demanders
Penalizing suppliers and demanders
Barriers to trade
Tariffs
Quotas
Vocab:
Voluntary export restraints
GATT
WTO
Customs unions
Common markets/free-trade areas

Ch. 13 Monopoly and Cartels

Market power
Marginal revenue is below market price
o Numerical illustration
o Geometric approach
o Algebraic approach
Graph (MR, MC, D, ATC, maybe AVC)
Compare monopoly to perfect competition: prices, profits, efficiency, quantity,
DWL

o
o

Barriers to entry: exclusive ownership, special knowledge, legal restrictions,

pricing strategies (limit pricing, predatory pricing)
Scale economies
As Q goes up, ATC goes down. Thats it.
Vocab: increasing returns to scale = economies of scale = decreasing cost
industry, and vice versa
Natural monopoly
Several definitions:
Dec ATC at least until it reaches market demand
MC is below ATC at least until market demand
Due to nature of technology, it is most cost-effective for only one firm to
produce good
New firms cannot join
Govt pricing strategies (nothing [profit max], ATC, or MC) and their
effect on price, quantity, profit, efficiency
Govt sets a price, then we go to that price on the demand curve.
Alternative explanation: govt setting a price creates a new MR curve
(remember squiggly line from class). This is straight across (like in perfect
competition) until it hits the demand curve. Then, it jumps down to the
original MR curve.
Collusion and merger
Explicit collusion/cartel vs merge
Why: increase P (requires market power) or dec ATC (requires economies
of scale)
Price discrimination
Necessary conditions:
Market power
Prevent resale
Be able to determine willingness to pay
Declining block pricing
International markets, dumping, reverse dumping
Not necessarily a bad thing

Ch. 14 Market Power and Public Policy

Check out the book chapter. This is mostly vocabulary.
Ch. 15 Externalities
Negative externality: there are extra social costs. Supply is too far to the right.
o On graph, find: Market equilibrium, social optimum, DWL
Positive externality: there are extra social benefits. Demand is too far to the left
o On graph, find: Market equilibrium, social optimum, DWL
Public policy responses that rely primarily on private interests
o Creating markets
Property rights: defining and enforcing
Unitizing ownership (single ownership)

Facilitating private contracts (restrictive covenants)

Social custom
Public policy responses that rely primarily on government intervention
Taxes (effluent taxes)
Subsidies
Tort law
Direct regulation
EX: Production techniques
EX: Emissions standards
Cost effective policies
Emissions fees: can set pollution at desired level without knowing cost
structure of firms.
Transferable emissions permits
Bubbles and offsets
Coase theorem

Ch. 16 Public Goods

Pure public goods
o Three characteristics that distinguish public goods from private goods
Consumption is non-competitive/non-exhaustive
Consumption is non-exclusive
Production is accompanied by positive externalities
Free riding
Market outcome: inefficiency & true demand (marginal social value
curve)
Public policy options
Make private
Social norms
Information as a public good
Govt provision
Mkt provision
Searching
Reputation/brand names
Warranties
Middlemen
Prices
Markets only work if ALL consumers have complete information =
FALSE
If SOME individuals search, the market price will come to embody the
information learned by those individuals
Ideas as public goods
Patents: technological innovation
Copyrights: creative works
Trademarks: brand names
Rational ignorance and uncertainty

MC and MB of information
Uncertainty
Insurance market: insurance premium
Futures market: futures price, spot price, speculators, hedgers
Economics of uncertainty
Risk-averse
Law of large numbers: the numerical average of the risks displays almost
no uncertainty as long as there are a large number of independent risks in
the pool (independent risks)
Portfolio diversification
Problems
Highly dependent risks
Moral hazard: probability of bad things happening changes after youve
been insured
Adverse selection: Lower-risk people leave insurance pools after premium
has been set, leaving high-risk people in the pool